World Energy Outlook: A Middle East Perspective

VOL. XLV

No 9

4 March 2002

GENERAL

World Energy Outlook: A Middle East Perspective

By Walid Khadduri

The following is the speech given by Walid Khadduri, Editor-in-Chief of the Middle East Economic Survey (MEES) at the Symposium on Priorities and Parameters for Energy Development in the Gulf Region, organized by the Crown Prince Court Research and Studies Division, Abu Dhabi, in association with the Middle East Program at the Royal Institute of International Affairs (Chatham House) held in Abu Dhabi, 18-19 February, 2002.

Looking at the world energy scene, one can see a glass either half-full or half-empty. Similarly, one can look at long-term energy trends, which are generally stable, or at hourly, daily and seasonal market developments, which are volatile and ever changing.

Long-Term Fundamentals

Long-term energy fundamentals show that there is a direct relationship between economic growth and energy. In the 20^th century, for example, world gross domestic product (GDP) increased 20 times, world population tripled, and energy consumption grew 40 times. The economic and population growth provided for rising energy demand, new patterns of energy utilization, incremental demand in new geographic areas, and incentives to invest billions of dollars annually in the worldwide energy industry and to diversify sources of energy.

The energy industry is global in nature. Resources are distributed unevenly worldwide, while demand growth varies among countries and regions in accordance with the economic development in each area at a particular time. The international companies have learned to cope with volatile situations and to forge an interdependence among nations – both in the production and marketing of resources.

This interdependence is demonstrated in the rise of the oil industry and particularly the evolving nature of oil’s share in the world energy basket, which has increased from around 10% at the turn of the 20^th century to approximately 35-40%, now and is projected to stay at this level until 2020. In the meantime, coal’s share has decreased from 85% to 26% during the past 100 years, while natural gas is gradually increasing its share to around 25% of the energy market in the foreseeable future.

While oil’s share, on the whole, has been stable, it has lost its market share in the power sector to natural gas, coal and nuclear power. Nonetheless, oil will remain predominant in transportation as long as the combustion engine is the primary machine used for cars.

The dominant role of oil in the global industry is not accidental. There are technologies available today, and have been around for some time, that could replace oil. However, oil reserves are plentiful worldwide and continue expanding at reasonable and competitive costs to other types of fuel. Moreover, OPEC has provided spare capacity to meet rising demand and emergencies which have ensured security of supply. Finally, oil is easier to transport and store – as well as less expensive – than other fuels which makes it more convenient than other sources of energy.

In the past two decades, world oil demand increased 20mn b/d, with 14mn b/d of this new demand coming from developing states. Projections for future trends indicate that by 2020:

· World demand is set to increase by 30-40mn b/d;

· 80% of the incremental demand will be in developing states;

· 62% of the new demand will be in the transportation sector;

· 85% of the new demand will be supplied by OPEC;

· 65% of the new demand is to come from the Middle East.

This large reliance on oil has raised two concerns in the industrial countries, one associated with energy security and the other with the environment. As a result, certain long-term measures have been taken to meet these two basic challenges, such as:

· Environmental legislation;

· Very high taxation of petroleum products;

· Strategic reserves by the IEA to meet emergency conditions;

· Intensive exploration for new sources of oil;

· Utilization of alternative sources of energy;

· Promoting new technologies to replace the combustion engine.

For its part, OPEC has been striving to safeguard the market-share of oil, as well as that of its member states, and to prolong the use of oil as far as possible. OPEC has been able to do so by providing ample supplies to meet rising global demand and by ensuring the security of supply, without interruptions, despite political upheavals. This has been achieved largely through the development of the massive reserves available to the member countries and through the expensive policy of retaining a spare production capacity that can be made available at short notice to meet emergencies.

The Constant Challenges

The fact that oil is a global commodity and is vital to the sustained growth of the world economy has raised the stakes in securing access to supplies, finding alternatives, providing oil at very inexpensive prices and safeguarding the environment. These issues are not separate one from another. They are mixed together in the decision-makers’ minds, as well as that of the public, and they surface constantly in the media as one package.

The first challenge facing the industry is the fact that around two-thirds of the world’s oil reserves are located in the OPEC countries, mainly in the Middle East. The problem with this geographical concentration of oil is that the Middle East is riddled with political problems and armed conflicts. Hence there is constant fear of insecurity of supply and a major disruption of the oil flow to world markets.

There can be no doubt that the Middle East has more than its fair share of political conflicts. However, it is also a fact that there has hardly been a disruption of oil supply in recent memory. Other than the short-lived oil boycott in the Fall of 1973, there has not been any political move to cut supplies to industrial countries. Moreover, when supplies were shut down for one reason or the other, such as in the case of the Iranian revolution in 1979 or during the Iraq-Iran war and the Iraqi invasion of Kuwait, the other producers in the region substituted for any shortfall, so much so that no shortages appeared. The reason for this is simple. Middle East countries, particularly Saudi Arabia and the other Gulf states, have at a very great expense adopted a purposeful policy of retaining spare capacity for industrial, market or political emergencies. Over and over again this policy has proven to work and the world has been spared many supply crises because of this measure that goes unnoticed by many industry observers when they write about security of supply.

This issue has come to the fore once more since the tragic events of 11 September. There have been increasing calls in the US to minimize dependence on Middle East oil, and even – if possible – to replace Middle East crudes with supplies from other regions. This, of course, is not a new phenomenon. Over 20 years ago, President Jimmy Carter launched Project Independence to free the US from imported oil – particularly that from the Middle East. The US today imports around 50% of its crude from the international markets.

There is an inherently contradictory element in this campaign. If the move is to de-link with Middle East sources of crude as much as possible, and to depend instead on new regions such as Russia and the Caspian, then one would assume that it is these states, and not the Middle East, that would maintain spare capacity equivalent to 10% and even as high as 25% of their production capability. It is very doubtful in these days of free enterprise that these producing countries are willing to shoulder such an expensive burden, or that the local private firms or super majors that are operating in these countries would be willing to shut in part of their capacity for strategic reasons. In fact, the opposite is true. The super majors have reduced their commercial stocks in mergers in order to reduce their costs and achieve higher profits. The newly-founded Russian firms are more eager to maximize market share than consider seriously strategic global interests.

The second challenge concerns the constant efforts undertaken by industrial countries to discover oil outside OPEC member countries. Every time a new region is tapped, or a discovery is made, one is flooded with articles and information about the demise of OPEC and its loss of market share.

The fact of the matter is that it is the business of the international oil companies (IOCs) to sustain current production, discover more oil, tap new gas reserves, cut down production costs and develop new markets. This has been the practice of the IOCs throughout the 20^th century and one can safely presume that they will go on pursuing the same policy, but with constantly changing means, during the 21^st century.

Should OPEC, or the Arab countries, worry about the rising production from Russia and the Caspian? Not really. These regions were the monopoly of Soviet firms until the past decade. Now they have opened up to international companies, and one can expect competition. However, oil-producing countries should start worrying if world economic growth slows down over a long period of time and oil demand shrinks. Market share competition then will drive prices down. But, if the world economy continues to grow at around 4% annually, and if new demand emerges in countries such as China, India and other Third World states to the tune of around 1.5mn b/d, it is believed then that there would be a stable supply/demand balance and that incremental production from both OPEC and non-OPEC countries would meet the rising demand.

What has been ironic for some time now is that Middle Eastern countries are prodded to produce more oil, make available larger and larger spare capacity, and open their markets to IOCs. At the same time they are told constantly that the industrial countries intend to dispense with their oil imports from the region and make their reserves redundant by importing crude from other regions.

The problem, however, is not whether OPEC member states will face a shrinking market in the near future. Experience has shown that markets expand, not shrink, albeit at different degrees and speed. The problem lies with the way oil revenue is spent in the oil-producing countries, the failure to build over half a century an alternative economy to that of total dependence on oil, the lack of transparency as regards how money is being spent, and the absence of democratic regimes that mull over and deliberate on policies over a period of time rather than the personalized decision-making process that has now become familiar in almost all the OPEC states.

OPEC oil ministers face several challenges every time they meet to determine the production ceiling for the organization and the quotas for their member states. There is the question of global supply and demand, seasonal adjustments, world economic growth and the rise or slowdown of oil supplies from a particular country or region at any particular time. The ministers must also think of other factors – mostly domestic, such as their country’s production capacity, investment rate of return, obligations to international oil firms operating in their state and the need for associated gas. However, perhaps the most difficult and critical matter to consider is the oil price projection assumed in the public budget. Because of the oil-producing countries total dependence on oil revenue, there is very little flexibility here and a dangerous reliance on income generated from oil.

The third factor is the technological challenges forging ahead in the medium and long terms – in the next 15 to 20 years. The list is long. There is the annual decrease of production costs by around 2.5%. This means in effect that the Canadian shale oil and Venezuela’s Orinoco heavy crude can be produced these days at around $16/B. There are also the 3-D seismic and information systems to define more precisely deep reservoirs without incurring the costs and time waste that companies had to endure previously. There is the technology to drill in the deep offshore, to around 1,800ms below sea level, instead of the 300-400ms of a few years ago. There is the need to clean crude oil from the various elements that contribute to pollution and weather developments that many scientists are attributing, rightly or wrongly, to hydrocarbons. Finally, there is the introduction of the fuel cell to replace the combustion engine in cars. This, of course, is technically available today. However, it is still not commercially attractive for the consumers. Much government funding has gone to develop this alternative and if and when it were to succeed, then it would deal a severe blow to the last bastion left for the oil market: transportation.

It goes without saying that there is not much that oil-producing countries can do to stop these technological developments. It is in the nature of our society to progress from one age to the next with the evolution of technology and the new alternatives that this provides us with. In the case of energy, the problem lies with the fact that OPEC’s national oil companies (NOCs), while they have performed admirably in sustaining substantial production levels with very little disruption and sometimes under very difficult and stressful conditions, nonetheless, they have not been able to make any significant contribution in the technological arena.

Why? NOCs are instruments of their shareholders, the oil-producing countries. Their declared purpose is to retain current markets and open new ones. However, it is also the avowed policy of the major producing countries to prolong the life-span of oil so that it can remain competitive with other fuels. This should not be very difficult since crude oil production, transportation, storage and marketing are much more competitive than other sources of energy, whether they be natural gas, coal or nuclear power. Nonetheless, the problem with oil is the environmental challenge. One way of dealing with this is to improve the quality of petroleum products to meet the new stringent standards that are being legislated worldwide.

There is no escape from this new fact of life. Serious and advanced discussions have been taking place for years now between IOCs and major car manufacturers about how to go about this issue. However, there is a total absence of the NOCs in this dialogue, not because they are not important on the world oil scene, but because they have not paid enough serious attention to the subject in the form of investments, research and policies. The focus has been on short-term marketing policies and the upgrading of refineries to meet the new requirements. But, however significant these measures might be, they are not the same as undertaking serious R&D that familiarize the professionals in these companies with the state of the new technology and make them fully aware of the challenges ahead, and allow them to invest in the technology that makes oil more environmentally friendly and hence prolong its lifespan.

What the NOCs have to do is what the super majors are doing: increase their oil resource base while investing in technology, and expand into the energy industry. The NOCs cannot survive limiting themselves either to their country’s resources, the narrow scope of activities they undertake so far, or the bureaucratic straightjackets imposed on them by their governments. The competition is too stiff to permit survival.

Short-Term Problems

While long-term trends are very much on the minds of oil executives since they have to plan for massive investments that will determine the course of the industry in the years to come, what really matters, however, are the day-to-day issues. These, in the final analysis, determine the price of oil in the world markets today, and hence the profitability of the companies, the rent to the producing states and the return to the shareholders.

In today’s industry, several issues play a dominant role in determining the level of prices. There is first the evolution of the world economy. Under normal circumstances, and as was witnessed during the nineties, world economic growth was rising around 4% annually, with major strides in the newly emerging economies of China and India, leading to world oil demand increases of approximately 1.5mn b/d. This was comfortable for both OPEC and non-OPEC, since the incremental demand was somewhat evenly split between the two groups.

The problem that we face today, and the question marks concerning the near future are: where is the world economy heading in the next few months and years? Has the recession in the west, particularly in the US, bottomed out? If so, will there be a quick or a slow recovery? What about Japan – the dynamic economy of Asia? Is it moving from a recession to a depression? Is Germany following suit? What about the war on terrorism? What impact would it have on global investments if it were prolonged over several years and in many oil-producing countries? The answers to these questions are not clear. They are becoming even more confusing as the US dominance prevails and its focus is limited to single and simplified issues in contrast to the complex matters at hand, particularly in the Middle East, and especially the Arab-Israeli conflict.

OPEC is a taker here. As matters stand today in early 2002, it can only wait and see. Basically, there is very little more that the organization can contribute other than what it has done so far. The approximately 5mn b/d production cut implemented by the 10 member states between 1 February 2001 and 1 January 2002 has reduced the organization’s production to extremely low levels and the idle production capacity to around 7mn b/d – not far from Russia’s production level today. As a result, it is inconceivable that a further production cut can be conceived without assuming a lack of discipline, problems with international oil firms operating in the member countries or shortages of associated gas that feed the power plants and the petrochemical factories.

However, what OPEC can do in this period is sustain the much sought-after credibility that it has always wanted but never gained until very recently. In fact, the cohesion among the OPEC member states since March 1999 has been unprecedented in the 40-year history of the organization. It is now apparent that the bitter experience of the 1998 price collapse, and the fact that it took some 15 months to arrive at a credible agreement to stabilize markets have driven home the point that it is better to reach agreement early on, before the price collapse, than wait for prices to crash and then act. The common purpose among the OPEC member states in the last few years has been to maintain reasonable prices, ensure stable markets and enhance on-going contacts among the member states in order to achieve the harmony that has been successfully achieved lately.

What OPEC has to do more, however, is institutionalize its relationship with the non-OPEC exporters and the consumers. There are no short cut or easy ways to do this. A number of approaches have to be adopted, all at the same time. There is definitely a need to cooperate with the non-OPEC exporters and bring them on board in the effort to stabilize prices. However, experience has shown that relations with non-OPEC producers have to be undertaken on a bilateral basis. Because each one has domestic and international obligations different from the other. Some of these conditions oblige some states to keep at arms length from collective relations with OPEC. Other states are new producers and much in debt. They look abhorrently at any call for production cuts to stabilize prices. However, and despite the pressures they are under from the local firms and IOCs to allow them to produce at maximum capacity, there is a need to explain to these countries, and to the operating companies, the benefits of stabilizing prices at reasonable levels.

As for the consumers, much progress has been achieved in the talks and meetings between OPEC and the International Energy Agency (IEA). Gone are the days when one organization boycotted the other. Just the other day, experts from both groups met here in Abu Dhabi in the 6^th such meeting between professionals from the member states of the two groups. Another important meeting is scheduled in Osaka, Japan next September bringing together some 75 producer and consumer countries. The venue is expected to approve the establishment of an International Energy Forum secretariat in Riyadh for the main purpose of encouraging such a dialogue and adding more transparency to the exchange of energy data.

The lack of transparency, and the absence of some essential data concerning reserves, production rates and costs have played havoc with prices – at the expense of both producers and consumers. The world markets today, for example, are focused on daily and hourly developments in the US, not just because the US constitutes one-fourth of the world oil market, but also because it is the most transparent of all. The lack of such on-time data for the rest of the world creates a confusing picture, resulting sometimes in wrong decisions.

Conclusion

There is today, irrespective of the many differences and interests among the many players, a serious desire on the part of producers and consumers to achieve and sustain stable energy markets. This is reflected in the producers’ objective of maintaining crude oil as a major component of the global energy basket as long as possible, and the consumers’ desire to find secure, clean and cheap sources of supply.

However, the producers, especially in the Middle East, face a serious challenge in the coming years. This is reflected in the increasing voices in the US, following the 11 September attacks, to de-link the relationship between the US and the Arab world and to import as little Arab oil as possible.

There is no question in many peoples’ minds in the Middle East that there is vital and urgent need to carry out a series of reforms in all major aspects of society. However, it is rather difficult to mobilize local public opinion in favor of reforms when there is a genuine and deeply rooted feeling of having to face double-standard policies being applied towards the Arabs, whether over the question of the Arab-Israeli conflict, sanctions or now terrorism.

Nevertheless, and despite the many political conflicts that afflict the Middle East, there is also a serious desire to separate the issue of energy supply from that of politics, and to proceed ahead to stabilize the oil markets. Furthermore, there is a new move – different from one country to the other in degree, intensity and timing – to invite international energy firms to participate in the exploration and development of oil and gas resources, invest in the downstream industry, and participate with local firms in the ownership and management of power stations.

There is no question that the world is gradually approaching a new era where new sources of energy will predominate. This is inevitable as technology advances, environment becomes critical and alternatives are needed to meet rising demand. This does not mean that the oil era is coming to an end. The world still has a long way to go before there is a viable and commercial alternative to the combustion engine. However, for the producing countries, this means that they have to put their house in order to lessen their dependence on oil since their options will be fewer than they were in the past.